Undone Deals

May 19, 2009

Mergers and acquisitions have been hit hard by the downturn, with Thomson Reuters reporting that the ratio of "withdrawn deals" to completed deals in 2008 was at an all-time high – higher even than during the tech meltdown of 2001.

The U.S. deals identified by Thomson Reuters in 2008 (including 11 deals announced in 2008 that cratered in early 2009) are composed of approximately 2,300 completed deals and 96 "withdrawn deals." In 70 of the withdrawn transactions, a firm agreement was reached but eventually terminated without being completed; the other 26 transactions were unsuccessful unsolicited offers (where no agreement was reached between buyer and the target company). Analysis of these completed and withdrawn transactions provides a number of insights about the effect of the downturn on M&A activity. 

The unsuccessful unsolicited offers are not truly "cratered deals" because the buyer and the would-be seller never reached an agreement at all. Nonetheless, a determined buyer proceeding on an unsolicited basis could be expected ultimately to prevail much of the time, even if the buyer must raise its price until shareholders press for acceptance and fiduciary concerns prompt the target’s board to accept in the absence of a better alternative for shareholders. 

The ratio of these unsuccessful unsolicited transactions to completed deals was approximately 1.5 times higher for 2008 compared with the corresponding ratio for 2006 and 2007. Perhaps not a surprising spike: The meltdown in stock prices would make many targets more attractive to buyers, while at the same time making the boards of target companies more resistant to selling at what they may perceive as fire-sale valuations. Hence, private overtures at perceived low prices would be more often resisted, prompting buyers to turn to public unsolicited offers to spark a transaction. In the face of increased resistance and financing constraints, however, buyers may not be willing or able to increase their prices to whatever it might take to clear the market. 

More interesting is the other category of "withdrawn deals" – those in which buyer and seller did reach an agreement, but for whatever reasons, the agreed, committed deal eventually came apart without being completed. These "cratered deals" are nightmares for companies that negotiate extensive protections to ensure their deal will be completed once it is agreed – break-up fees, narrowly crafted "fiduciary outs" for the target, limited definitions of "material adverse change" that would excuse the buyer from its obligations, rights to sue for specific performance, etc. 

A useful metric for analyzing this set of transactions is the "cratered deal ratio," that is, the total number of agreed-but-cratered deals in a particular time period or segment, divided by the total number of agreed deals (whether completed or cratered) in that time period or segment. 

The good news is that, although the cratered deal ratio was approximately double for 2008 what it was for 2006-2007, the vast majority of announced, agreed transactions were in fact completed – taken as a whole, the ratio of cratered deals to total agreed deals in the U.S. was only 3 percent for 2008. Despite the tumultuous seizing up of credit markets and the volatility in valuations, most agreed deals got completed. 

The more interesting insights, however, come from the 70 agreed transactions that did come apart during this period. 

Financial buyers present more completion risk than strategic buyers. The cratered deal ratio with financial buyers (6.8 percent) was nearly three times higher than for strategic buyers (2.4 percent). In 2006 and 2007, the cratered deal ratio between financial and strategic buyers was about the same, so clearly the credit crunch and valuation downturn in 2008 hit deals with financial buyers disproportionately hard. 

The cratered deal ratio was approximately 13 times greater among deals with publicly traded targets compared to private company targets. It is, of course, much easier to "lock up" a deal with a private company. Often there is a relatively small number of shareholders that control a majority of the target’s stock and can commit to the deal at the negotiating table or shortly following signing, so private targets usually are not at much risk of a competing superior offer disrupting the deal (unlike public companies, which cannot truly lock up the deal until a shareholders meeting is held a few months or more after the deal is announced, or until a majority of shareholders tender in the case of a tender offer, during which time a "fiduciary out" usually allows competing bidders to come to the table). Also, the fact that the public target’s shareholders are not "at the table" means there is more uncertainty about whether they will approve the deal, and the delay required to obtain their approval allows time for other risk events to occur. Larger transactions that face antitrust hurdles also tend to involve public company targets more than private targets. 

In 2006 and 2007, public company targets similarly had a much higher ratio of cratered-to-completed deals compared with private targets, but the frequency of the problem with public targets in 2008 was more than double what it was in those prior years. Presumably, public companies spiked this way in 2008 in part because more of the larger deals and debt-laden deals – key drivers of deals coming apart – involve public company targets. 

Stock-for-stock mergers also comprise more of the public company deals, and deteriorating value in the buyer’s stock was a significant part of the cratered landscape in 2008. 

The amount of debt carried by the target, relative to the nominal purchase price being paid, is a telling factor. 

As the amount of target company debt gets larger, relative to the purchase price, the cratered deal ratio jumps dramatically. For deals involving targets that had no debt, the cratered deal ratio was 4.67 percent. In contrast, when the target had debt equal to up to 10 percent of the nominal purchase price, the cratered deal ratio jumped to 14.3 percent. When the debt carried by the target was between 10 percent and 100 percent of the nominal purchase price, the ratio was an even higher 22.2 percent. 

And, for those cases in which the target’s debt was greater than the nominal purchase price, the cratered deal ratio was 29.4 percent. 

This debt load information is incomplete, because a number of reported transactions involved private companies where such information was not available. Nonetheless, there were a substantial number of transactions with such information reported, and the relationship is striking. 

In 2006 and 2007, the same relative impact generally prevailed, i.e., the higher the amount of target debt-to-price, the higher the experience of cratered deals. But the most heavily burdened targets (where the debt assumed is greater than the nominal purchase price) did not experience significantly higher problems in 2008 compared with prior years – it appears that those are simply more challenging transactions to complete in any year. In the mid-range, however, where the target’s debt was more than zero but less than 1-to-1 compared to the purchase price, 2008 saw double (or more) the frequency of cratered deals, compared with 2006 and 2007. 

It appears that these mid-range categories ordinarily would not encounter difficulty securing financing, but got taken by surprise by the freeze up in credit markets. 

The incidence of cratered deals broadly cut across several industry lines. It’s no surprise that financial services companies and energy companies – two industries whose valuations fell dramatically – had among the highest ratios of cratered-to-completed deals (6.7 percent for energy companies and 4.9 percent for financial companies). But the ratio was just about as high in the media and entertainment industry and materials industries, and higher than the overall averages in telecommunications and health care as well. 

In 2006 and 2007, there also was a broad distribution of cratered deals across industries, but on a comparative basis, the experience of cratered deals spiked most in financial services, energy, and materials industries – those that experienced the greatest volatility in 2008. In technology industries, by contrast, there was no spike in the ratio of cratered deals over these time periods. 

Finally, transaction size made a difference. The cratered deal ratio among deals above $1 billion was approximately 14 percent, while the ratio among deals with a value of $100 million or below was only 3 percent. Smaller deals are of course easier to finance, easier to lock up and less likely to face antitrust hurdles, but when one considers the extensive work and financing efforts that are assembled to put together larger deals, the disparity is nonetheless noteworthy. 

In 2006 and 2007, larger deals ($1 billion-plus) also cratered at a much higher rate than smaller deals, but across each category of deal-size, the cratered deal ratio more than doubled in 2008 compared with the prior years. Deals of all sizes had more problems in 2008, and the larger deals especially so. 

So, to minimize the risk of acquisitions busting up, buyers should focus on private company targets that are not highly leveraged relative to the purchase price, and lean toward bite-sized purchases rather than the headline-grabbing larger deals. And sellers should target strategic buyers more than financial ones, at least at the moment.  

This article was prepared by Gibson Dunn associates Raymond Yee, Kyle Kreiss, Chris Bors and Mark Riso, members of the corporate transactions group based in Gibson Dunn’s Palo Alto office. 

This article appeared in the Daily Journal, Focus Column, May 15, 2009.  Reprinted with permission, Daily Journal Corp., © 2009.